Author Archives: Hedge Fund Attorney

FINRA Proposes Amendments to Rule 5122

Proposal to Require Greater Involvement in Private Placements by Broker-Dealers

FINRA recently proposed amendments to Rule 5122 which would increase Broker-Dealer compliance responsibilities with respect to private placements in which the Broker-Dealer “participates.”  FINRA noted that the vast majority of private placements currently remain outside the purview of the rule as it is currently written.  As FINRA’s stated intention is to increase investor protection, the amended rule is designed to combat fraud and abuse, by expanding oversight to all private placements in which a FINRA member participates, subject to certain exemptions.

Current FINRA Rule 5122

In general FINRA Rule 5122 requires a FINRA member firm which acts as the issuer of a private placement to adhere to the following requirements:

  • the private placement offering document must include the indended use of offering proceeds, expenses, and the amount of selling compensation to be paid to the broker-dealer and its associated person;
  • 85% of the offering proceeds must be used for the business purposes described in the offering documents (i.e. only up to 15% of the proceeds from the offering may be used to pay for offering costs, discounts, commissions or any other cash or non-cash sales incentives); and
  • the offering documents must be submitted to FINRA for review at or prior to the time the offering documents are provided to any prospective investor (but the firm does not need to delay the offering until it receives a “no-objections” letter from FINRA).

There are various exemptions available under the rule including if the private placement offering is sold to:

  • Institutional accounts
  • Qualified purchasers
  • Qualified institutional buyers
  • Investment Companies
  • Banks
  • Employees of the issuers

In addition, certain private placements are not subject to the rule.

Major Part of Proposal

In general the major part of the proposed amendment is to apply the requirements of the rule to broker-dealers who “participate” (within the meaning of FINRA Rule 5110(a)(5), see below) in a private placement offering as opposed to only those broker-dealers (and control entities) who act as the cheap celebrex online issuer in a private placement.  The proposal will significantly expand the scope of the current rule – third-party marketers who enter into selling arrangements with respect to private fund interests will now be subject to greater oversight with respect to these arrangements.

Participation

Rule 5110(a)(5) defines “participation” as the following:

Participation in the preparation of the offering or other documents, participation in the distribution of the offering on an underwritten, non-underwritten, or any other basis, furnishing of customer and/or broker lists for solicitation, or participation in any advisory or consulting capacity to the issuer related to the offering, but not the preparation of an appraisal in a savings and loan conversion or a bank offering or the preparation of a fairness opinion pursuant to SEC Rule 13e-3.

The proposal also would remove the wholesaling exemption (i.e. selling through affiliated broker-dealers) for member firms.

Conclusion

It is not clear now how this would affect the business of third-party marketers and whether this will have a chilling affect on selling agreements.  This proposed amendment also highlights FINRA’s aggressive expansion of regulatory oversight.

If you have specific comments on the proposal, especially with respect to certain elements (investor protection, filing requirements, burdens/efficiencies, 85% of offering proceeds go to the use of proceeds), you should submit comments on the proposal by March 14, 2011

For more information, please see FINRA Regulatory Notice 11-04.

Other good information for broker-dealers FINRA Regulatory Notice 10-22.

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Bart Mallon is an attorney focused on the investment management industry and provides regulatory and compliance services to the broker-dealer community through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

New Form ADV Part 2 Update & Overview

Registered investment advisers (both SEC and state) will need to file their annual form ADV update within 90 days of the end of the fiscal year, which for most firms will be March 31, 2011.  For many firms this will mean that they will also need to draft and submit the new Form ADV 2 which was adopted by the SEC in July of 2010 (see previous post). As many firms have had many questions about the new form, including what new content is required and how long it will take to complete the new form, this article will provide a summary of:

  • Background on the new Part 2
  • The structure and disclosure items of the Firm Brochure (Part 2A)
  • The structure and disclosure items of the Brochure Supplement (Part 2B)
  • Overview of states which have adopted new Part 2

Background

On July 21, 2010, the Securities and Exchange Commission (“SEC”) adopted a new Part 2 that became effective October 12, 2010.  The old Part II (and Schedule F which qualifies much of the information on the old Part II) contained a series of check-the-box options and also provided much of the same information which is also provided on Form ADV.  The new Part 2 will no longer be in the check-the-box format.  Instead, it will take the form of a narrative brochure written in plain English–the purpose of which is to provide clients with a more clear disclosure of the adviser’s business practices, conflicts of interest, and background.

The new Part 2 consists of three parts:

  1. The “Firm Brochure” (Part 2A)
    • SEC-registered firms and firms registered in states that have adopted the new Part 2 must complete.
    • Filed electronically on the IARD system.
    • Publicly available.
  2. A Wrap Fee Program Brochure (Part 2A, Appendix 1)
  3. The “Brochure Supplement” (Part 2B)
    • SEC-registered firms and firms registered in states that have adopted the new Part 2 must complete.
    • Not filed electronically.
    • Not publicly available.

The SEC has not provided a specific form that IAs must use when preparing the new Part 2.  The following provides general guidelines on how to structure the Firm Brochure and Brochure Supplement, as well as what content to include.  A full version of the new Part 2 instructions is available here.  Firms applying for SEC registration for the first time after January 1, 2011 are required to use the new Part 2.  Existing SEC-registered firms may use either the old Part II or the new Part 2 between October 12, 2010 and December 31, 2010.  However, beginning January 1, 2011, firms will have to use the new Part 2 for their 2011 annual updating amendment.

More information about the filing and delivery deadlines for the new Part 2A and 2B are available here.

Firm Brochure (Part 2A)

The Firm Brochure requires an adviser to provide information about the firm’s business practices and conflicts of interest. Many of the disclosure items are similar to those required in the old Part II, such as a discussion of the advisory business and the types of clients.  However, new disclosure items include a discussion of material changes since the last annual amendment as well as a discussion of potential conflicts of interest and how the firm will address such conflicts.

The Brochure consists of 18 separate disclosure items for SEC-registrations and additional items specifically for state-registrations.  Each item must be addressed, even if it is not applicable to the adviser.  The adviser may simply state it is not applicable.  The following is a summary of the disclosure items in the Firm Brochure:

  • Item 1 – Cover Page
    • Firm name, business address, contact information, website (if any) and the date of the Brochure.
    • Specific disclaimer stating the Brochure was not approved by the SEC or any state authority.
    • If the firm refers to itself as a “registered investment adviser,” a specific disclaimer that registration does not imply a certain level of skill or training.
  • Item 2 – Material Changes
    • If the firm is making an annual update, the Brochure must discuss material changes in the Brochure since the last annual update in a summary.  The summary can also be a separate document attached to the Brochure.
  • Item 3 – Table of Contents
    • Must be detailed enough so that clients can locate topics easily.
    • Must list items in the same order as they are listed in the Brochure, and contain the same headings.
  • Item 4 – Advisory Business
    • Describe the firm, how long it’s been in business, and identify the principals.
    • Describe the types of advisory services offered.
      • If the firm specializes in a particular type of services, e.g. financial planning, quantitative analysis, etc. provide greater detail.
      • If the firm provides investment advice only with respect to limited types of investments, explain and disclose that advice is limited in such way.
    • Explain whether the firm tailors advisory services and whether clients can impose restrictions on investments.
    • If the firm participates in wrap fee programs, describe the differences in how such accounts are managed versus other accounts and disclose that the firm receives a wrap fee.
    • If the firm manages client assets, disclose the amount managed on a discretionary basis and the amount managed on a non-discretionary basis.
  • Item 5 – Fees and Compensation
    • Describe how the firm is compensated and provide a fee schedule.  Note: This requirement is not required for Brochures delivered solely to qualified purchasers.
    • Provide other compensation-related disclosures: whether fees are deducted from client assets or whether clients will be billed for fees; any other types of fees (custodian fees, mutual fund expenses, brokerage/transaction costs); payment of fees in advance or arrears; and asset-based sales charges or service fees.
  • Item 6 – Performance-Based Fees and Side-By-Side Management
    • Discuss whether the firm charges performance-based fees or supervised persons manage accounts that pay such fees; and discuss how the fees are charged.
    • In addition, if the firm or supervised persons also manage accounts that do not charge such fees, discuss the potential conflicts of interest and how the firm will address such conflicts.
  • Item 7 – Types of Clients
    • Describe the firm’s clients.
    • Describe any requirements for opening/maintaining an account.
  • Item 8 – Methods of Analysis, Investment Strategies and Risk of Loss
    • Describe the methods of analysis and investment strategies used to formulate investment advice.  Disclose that investing in securities involves risk of loss.
    • For significant investment strategies or methods of analysis, discuss material risks involved with such strategies and methods.  If there are significant or unusual risks, discuss in detail.  If strategies involve frequent trading, discuss how frequent trading affects performance.
    • If the firm recommends primarily a particular type of securities, explain the material risks.  If there are significant or unusual risks, discuss in detail.
  • Item 9 – Disciplinary Information
    • Disclose material facts about legal or disciplinary events about the firm or a management person.  This item lists events that are presumed to be material if they occurred in the prior 10 years, unless (1) the event was resolved in the firm’s or the management person’s favor, or was reversed, suspended or vacated, or (2) the firm rebutted the presumption of materiality to determine that the event is not material.
    • In the interest of full and fair disclosure of material facts, disclose events not on the list, events not presumed material, and/or events that are more than 10 years old.
    • The Firm can rebut events that are presumed material.
  • Item 10 – Other Financial Industry Activities and Affiliations
    • Discuss whether the firm or management persons are registered or have pending applications to register as broker-dealers, broker-dealer reps, FCMs, CPOs, CTAs, or associate persons.
    • Describe material relationships with related financial industry participants (e.g. broker-dealers, registered reps of broker-dealers, investment companies or other pooled investment vehicles, FCMs, CPOs, CTAs, accounting firms, law firms, real estate brokers, etc.).
    • Describe material conflicts of interest that arise from such relationships and how those conflicts are addressed.
    • If the firm selects or recommends other investment advisers for clients, the firm must disclose compensation arrangements (if any) with those advisers and any other business relationships with such advisers, as well as any material conflicts of interest and how the firm address them.
  • Item 11 – Code of Ethics, Participation or Interest in Client Transactions and Personal Trading
    • Include a summary of the code of ethics and state a copy is available upon request.
    • If the firm or a related person:
      • (i) recommends to clients, or buys or sells for client accounts, securities in which the firm or a related person has a material financial interest;
      • (ii) invests in the same securities (or related securities, e.g., warrants, options or futures) that the firm or a related person recommends to clients; or
      • (iii) recommends securities to clients, or buys or sells securities for client accounts, at or about the same time that the firm or a related person buys or sells the same securities for the firm’s own (or the related person’s own) account, then the firm must describe the practice and discuss conflicts of interest (including how such conflicts are addressed).
  • Item 12 – Brokerage Practices
    • Describe how the firm selects brokers and determines the reasonableness of brokers’ compensation
    • If the firm receives research or other products or services other than execution from a broker-dealer or a third party in connection with client securities transactions (“soft dollar benefits”), disclose the firm’s practices and discuss the conflicts of interest they create.  Provide more detail for products/services that do not qualify under the Section 28(e) safe harbor.
    • If the firm considers, in selecting or recommending broker-dealers, whether the firm or a related person receives client referrals from a broker-dealer or third party, disclose this practice and discuss the conflicts of interest it creates.
    • If the firm routinely recommends, requests or requires that a client direct the firm to execute transactions through a specified broker-dealer, describe the firm’s practice or policy.
    • If the firm permits a client to direct brokerage, describe the practice.
    • Describe whether and under what conditions the firm aggregates the purchase or sale of securities for various accounts.
  • Item 13 – Review of Accounts
    • If the firm periodically reviews client accounts, describe the frequency and nature of review, as well as the titles of the persons who conduct the review.
    • If accounts are reviewed on other than a period basis, describe what triggers review.
    • Describe the content and indicate the frequency of regular reports.
  • Item 14 – Client Referrals and Other Compensation
    • If a non-client provides economic benefit to the firm for providing investment advice or services to clients, describe the arrangement, potential conflicts of interest and how such conflicts are addressed.
    • If the firm or related persons compensate any non-supervised persons for referrals, describe the arrangement and compensation.
  • Item 15 – Custody
    • If the firm has custody of client assets and a qualified custodian sends quarterly, or more frequent, account statements directly to your clients, explain that clients will receive account statements from the broker-dealer, bank or other qualified custodian and that clients should carefully review those statements.
    • If the firm also provides statements, urge clients to compare such statements with those provided by the qualified custodian.
  • Item 16 – Investment Discretion
    • If the firm has discretionary authority over accounts, disclose this, along with any limitations clients may place on that authority.
    • Discuss procedures before discretionary authority is assumed.
  • Item 17 – Voting Client Securities
    • Describe voting policies for client securities, if any.  Discuss any conflicts of interest and how such conflicts are addressed.  Explain that a copy of the policies are available upon request.
    • If the firm does not vote client securities, disclose that fact.
  • Item 18 – Financial Information
    • If the firm requires or solicits prepayment of more than $1,200 in fees per client, 6 months or more in advance, include a balance sheet for the most recent fiscal year.
    • If the firm has discretionary authority over client assets, custody of client funds or securities, or require prepayment discussed above, discuss any financial conditions that purchase nolvadex are reasonably likely to impair the ability to meet contractual commitments with clients.
    • Discuss any bankruptcy petitions during the past 10 years.
  • Item 19 – Requirements for State-Registered Advisers
    • Identify and describe the formal education and business background of principal executive officers and management persons.
    • Describe any business in which the firm is actively engaged (other than the provision of investment advice) and amount of time spent.
    • In addition to the fees discussed in Item 5, if the firm or a supervised person is compensated for advisory services with a performance-based fee, explain how the fees are calculated and discuss the conflict of interest.
    • Disclose material facts about certain disciplinary items and other financial industry relationships or arrangements.

Brochure Supplement (Part 2B)

The Brochure Supplement requires an adviser to provide information about the certain advisory personnel.  The following is a summary of the disclosure items in the Brochure Supplement.

The Firm must prepare a Brochure Supplement for (i) any supervised person who formulates investment advice for the client and has direct client contact and (ii) any supervised person who has discretionary authority over the client’s assets.  A Supplement is not required if the supervised person has no direct client contact and has discretionary authority over client assets only as part of a team. Note: If investment advice is provided by a team of more than five supervised persons, Brochure Supplements only need to be prepared for the five supervised persons with the most significant responsibility for the day-to-day advice.

  • Item 1 – Cover Page
    • Identify the advisory firm and the supervised persons covered in the Supplement (include name, business address, and phone number).
    • Standard disclaimer similar to the one in the Firm Brochure.
  • Item 2 – Educational Background and Business Experience
    • Describe the supervised person’s formal education and business background for the past 5 years.
    • Include professional designations, if any.
  • Item 3 – Disciplinary Information
    • Discuss the material facts related to any legal or disciplinary events that are material to a (prospective) client’s evaluation of supervised persons. This item lists events that are presumed to be material if they occurred in the prior 10 years, unless (1) the event was resolved in the supervised person’s favor, or was reversed, suspended or vacated, or (2) the firm rebutted the presumption of materiality to determine that the event is not material.
    • In the interest of full and fair disclosure of material facts, disclose events not on the list, events not presumed material, and/or events that are more than 10 years old.
    • The Firm can rebut events that are presumed material.
    • Disclose any event for which the supervised person has ever resigned or otherwise relinquished a professional attainment, designation or license in anticipation of it being suspended or revoked (other than for suspensions or revocations for failure to pay membership dues), if the firm knows or should have known that the supervised person relinquished his or her designation or license.
    • Note: If a Brochure Supplement is delivered electronically, the firm may disclose that a supervised person has a disciplinary event and provide a ink to BrokerCheck or IAPD (along with an explanation of how the client can access the disciplinary history).
  • Item 4 – Other Business Activities
    • If the supervised person is actively engaged in any investment-related business, including registration (or pending registrations) as a broker-dealer, registered representative of a broker-dealer, futures commission merchant (“FCM”), commodity pool operator (“CPO”), commodity trading advisor (“CTA”), or an associated person of an FCM, CPO, or CTA, disclose this fact and describe the business relationship.
  • Item 5 – Additional Compensation
    • If a non-client provides an economic benefit to the supervised person, describe the arrangement (not including regular salary).
  • Item 6 – Supervision
    • Discuss how supervised persons are supervised, including how the firm monitors advice provided to clients.
    • Provide the name, title, and phone number of the person responsible for supervising the supervised persons.
  • Item 7 – Requirements for State-Registered Advisers
    • Disclose material facts about certain disciplinary items.
    • Discuss any bankruptcy petitions.

[Note: the SEC recently extended the date for compliance with Part 2B.]

States That Have Adopted the New Part 2

The following states have followed suit and adopted the new Part 2 or informally indicated an intent to do so.

  • Alaska – adopted the new Part 2 (more information available here)
    • October 12, 2010 – December 31, 2010: IA applicants and currently registered IAs may use either the old Part II or new Part 2.
    • As of January 1, 2011: IA applicants are required to use the new Part 2 and registered IAs must file the new Part 2 by no later than the registrant’s next amendment filing or its annual updating amendment filing, whichever comes first.
  • Arizona – adopted the new Part 2 (more information available here)
    • October 12, 2010 – January 1, 2011: currently registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update
    • As of January 1, 2011: IA applicants must use the new Part 2.
  • California – adopted the new Part 2 (more information available here)
    • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs may use either the old Part II or the new Part 2.
    • As of January 1, 2011: IA applicants will have to file the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
  • Colorado – will require but not sure starting when
  • Connecticut – adopted the new Part 2 (more information available here)
    • October 12, 2011 – December 31, 2010: IA applicants and currently registered IAs may use either the old Part II or the new Part 2.
    • As of January 1, 2011: IA applicants will have to use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
    • As of January 1, 2011: IAs registered on or before December 31, 2010 should file the new Part 2, no later than June 1, 2011.
  • Illinois – will require but not sure starting when
  • Indiana – adopted the new Part 2 (timelines may have been updated) (more information available here)
    • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs may use either the old Part II or new Part 2.
    • As of January 1, 2011: IA applicants are required to use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
  • Maine – adopted the new Part 2 (more information available here)
    • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs may use either the old Part II or new Part 2.
    • As of January 1, 2010: IA applicants must use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
  • Maryland – adopted the new Part 2 (more information available here)
    • As of October 12, 2010: IA applicants must use the new Part 2 as part of its initial application and any amendment.
    • October 12, 2010 – December 31, 2010: currently registered IAs and those pending registration as of October 12, 2010 may use either the old Part II or the new Part 2 for any amendments
    • As of January 1, 2011: registered IAs must file the new Part 2 by no later than the registrant’s next amendment filing or its annual updating amendment filing, whichever comes first.
  • Massachusetts – adopted the new Part 2 (more information available here)
    • October 12, 2010 – December 31, 2010: currently registered IAs are required to file the registrant’s next annual updating amendment using the new Part 2; until such time, the registrant may use the old Part II for regular amendment filings.
  • Ohio – adopted the new Part 2 (more information available here)
    • October 12, 2010 – December 31, 2010: IA applicants and currently registered IAs filing amendment may use either the old Part II or the new Part 2.
    • As of January 1, 2011: currently registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.  IA applicants are required to use the new Part 2.
    • As of April 30, 2011: registered IAs must have converted to the new Part 2.
  • Oregon – adopted the new Part 2 (more information available here).
    • October 12, 2010 – January 1, 2011: IA applicants and currently registered IAs filing amendment may use either the old Part II or the new Part 2.
    • As of January 1, 2011: IA applicants must use the new Part 2 and registered IAs will need to incorporate the new Part 2 as part of any amendment or required annual update.
  • Tennessee – adopted the new Part 2 (more information available here).
    • October 12, 2010 – December 31, 2010: IA applicants and currently registered IAs filing amendment may use either the old Part II or the new Part 2.
    • As of January 1, 2011: applicants must use the new Part 2 and registered IAs must file the new Part 2 by no later than the registrant’s next amendment filing or its annual updating amendment filing, whichever comes first.
  • Texas – currently in comment period, final approval expected in mid-2011, encouraging use of the new Part 2 (more information available here).

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Bart Mallon Esq. is a hedge fund attorney and provides hedge fund compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

Form ADV Requirements for Exempt Reporting Advisers

As we’ve discussed previously, the SEC has proposed two new exemptions from SEC registration for certain firms who would otherwise be required to register with the SEC as investment advisers:

  1. Section 203(l) (see Rule 203(l)-1) generally exempts investment advisers who only advise one or more “venture capital funds” and
  2. Section 203(m) (See Rule 203(m)-1) generally exempts investment advisers who only advise private funds and have AUM in the U.S. of less than $150MM.

To implement these new exemptions and to assist the SEC with identifying such advisers, their owners, their business models, and any potential risks to investors, proposed Rule 204-4 would require these “exempt reporting advisers” (“ERAs”) to submit, and to periodically update, reports to the SEC by completing specific items on Form ADV.

This article provides an overview of what information ERAs would have to report.

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ERA Reporting Items

Proposed Rule 204-4 requires exempt reporting advisers to provide the SEC with the following items on Form ADV:

  • Item 1 – Identifying Information
    • A new question would require ERAs (and registered advisers) to indicate whether the adviser had $1 billion or more in AUM to assist the SEC in identifying excessive incentive-based compensation arrangements.
    • ERAs (and registered advisers) would be required to provide contact information for the adviser’s chief compliance officer, indicate whether any control person is a public reporting company, and add “limited partnership” as a cohise advisers can select to indicate how their organization is formed.
  • Item 2C – SEC Reporting by Exempt Reporting Advisers
  • Item 3 – Form of Organization
  • Item 6 – Other Business Activities:  this item would require the ERAs to indicate the advisers other business activities.  The list of activities would be expanded to include trust companies, registered municipal advisors, registered security-based swap dealers, majority security-based swap participants, and accountant firms.
  • Item 7 – Financial Industry Affiliations from Private Fund Reporting: this item would be expanded as Item 6 will be expanded.
  • Item 10 – Control Persons
  • Item 11 – Disclosure Information
    • ERAs (and registered advisers) would have to indicate whether the disclosure (i.e. criminal, regulatory) pertains to the adviser or any of its supervised persons
  • Schedule A – Direct Owners
  • Schedule B – Indirect Owners
  • Schedule C – Amendments to Schedule A and B
  • Schedule D
    • Items 6 and 7.A. would require additional information corresponding with the answers provided in Items 6 and 7 in the main part of Form ADV.
    • Item 7.B. would require ERAs (and registered advisers) to provide more information about the private funds they (and not their related persons) advise, which generally includes all pooled investment vehicles, regardless of whether they are organized as limited partnerships.
    • Item 7.B.1. would require ERAs (and registered advisers) to provide more information about the basic organizational, operation, and investment characteristics of the fund, amount of assets, nature of the investors, and service providers.
    • Part A of Item 7.B.1. would also require additional information including:
      • the name of the fund (including an option to preserve the anonymity of the private fund client);
      • the state or country where the fund is organized;
      • the name of the general partner, directors, trustees or other persons with similar positions;
      • the organization of the fund (e.g. master-feeder);
      • regulatory status of the fund; and
      • other questions about the fund’s investment activities (e.g. size of the fund, gross/net assets, minimum investment amounts, conflicts of interest, etc.)
    • Part B of Item 7.B.1. would require ERAs (and registered advisers) to provide information about the 5 types of service providers that generally perform the “gatekeeper” role for a fund–auditors, prime brokers, custodians, administrators and marketers.

The ERA would not be required to prepare a client brochure (Form ADV Part 2).

Updates to Form ADV

In addition to filing an initial Form ADV, ERAs would also be required to file updating amendments (pursuant to the new amendment to Rule 204-1).  Rule 204-1 would require ERAs, like registered advisers, to amend Form ADV:

  • at least annually, within 90 days of the fiscal year end;
  • more frequently, as required by Form ADV.  The new General Instruction 4 of Form ADV would require ERAs to update Items 1, 3, and 11 if they become inaccurate in any way.  They would be required to update Item 10 if it becomes materially inaccurate; and
  • pursuant to Rule 204-4, the ERA would have to amend Form ADV when it ceases to be an ERA (indicate it is filing a final report pursuant to Rule 204-4).  Note: many times, the adviser would be simultaneously applying for registration.

Filing Deadlines

ERAs would be required to file their initial report on Form ADV by August 20, 2011.

Filing Fee

The ERAs would have to pay a filing fee charged by FINRA.   Currently, the SEC anticipates that the fees would be the same as those for registered IAs and range from $40 to $200, based on AUM.

Other Items

Why Form ADV?

The SEC has proposed for ERAs to use Form ADV to meet their reporting requirement because the Buy viagra china Form ADV and IARD system are already established and doing so avoids additional delay and expense related to creating a new form.  In addition, many ERAs will already have to use Form ADV for their state registrations – using Form ADV allows such advisers to satisfy the state requirement and Rule 204-4 in a single filing.  The ERA reports filed via Form ADV will be publicly available on the SEC’s website.

Other Changes to Form ADV

Form ADV would be re-titled to reflect its dual purpose–as the “Uniform Application for IA Registration” and “Report by Exempt Reporting Advisers.”  The ERA would indicate that it was reporting to the SEC, rather than registering with the SEC.

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Other related hedge fund articles:

Bart Mallon Esq. is a hedge fund attorney and provides hedge fund compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

Hedge Fund Events October 2010

The following are various hedge fund events happening this month.  Please email us if Safe site to buy cialis you would like us to add your event to this list.

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October 3-5

October 3-5

October 4-5

October 4-5

October 4-5

October 4-5

October 5-6

October 5-7

October 6

October 6

October 6

October 7

October 8

October 12-13

October 13

October 13

October 14-16

October 14-15

October 18

October 18-19

October 19

October 20

October 20-22

October 25-26

October 25-27

October 27

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Bart Mallon, Esq. runs the hedge fund law blog and provides hedge fund registration and compliance services to hedge fund managers through Cole-Frieman & Mallon LLP, a leading hedge fund law firm.  He can be reached directly at 415-868-5345.

California Adopts New Part 2 of Form ADV

At the end of July, the SEC adopted amendments to Form ADV Part 2 and the related rules.  The amended Form ADV Part 2 will be used by SEC-registered advisers to meet their disclosure obligations and generally describe the adviser’s services, fees, and strategies.

On September 1, 2010, the California Department of Corporations followed suit and announced its adoption of the new Part 2 as well, effective October 12, 2010 (see California ADV Part 2 Announcement).  This effective date corresponds with the effective date of the SEC’s rule changes.  The Department’s decision will help bring consistency between state and SEC investment adviser registration requirements.

New ADV Part 2

The amended Form ADV Part 2 consists of three parts:

  • the “Firm Brochure” (Part 2A),
  • a Wrap Fee Program Brochure (Part 2A, Appendix 1), and
  • the “Brochure Supplement (Part 2B).

Every investment adviser must complete the Firm Brochure and the Brochure Supplement.  The Firm Brochure, which is filed electronically with the SEC on the IARD system, will include information about the adviser and its business. The Brochure Supplement, which is a brief disclosure document about certain personnel of the adviser, will be provided to clients but not filed with the SEC.

In addition, the new Part 2 will no longer be in the check-the-box format.  Instead, it will take the form of a narrative brochure written in plain English–the purpose of which is to provide clients with a more clear disclosure of the adviser’s business practices, conflicts of interest, and background.

Compliance Dates

Effective October 12, 2010,  for California registered investment advisers, the relevant compliance dates for the new ADV Part 2 are:

  • As of January 1, 2011 all new investment adviser applicants will have to file, through the IARD, the new Part 2 of Form ADV as part of their application.
  • As of January 1, 2011 all licensed investment advisers will need to incorporate the new Part 2 of Form ADV with their next filing of an amendment to Form ADV, or their annual updating amendment to Form ADV.
  • Between October 12, 2010 and January 1, 2011 applicants and current licensed investment advisers filing amendments to their Part II of Form ADV may use either the current Part II or the new Part 2.

With this change, investment advisers should review and become familiar with the new Part 2.  Advisers that are currently registered with the California Securities Regulation Division will have to incorporate the new Part 2 when they file amendments to Form ADV and also when they file the required annual update.  For most advisers with a December 31, 2010 year-end, the deadline for the annual update will be March 31, 2011.

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Bart Mallon, Esq. runs the Hedge Fund Law Blog and provides investment adviser registration and compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

Series 66 Exam

This exam is required by certain states for an individual who wants to register as an investment adviser representative and securities agent.  Passing the Series 66 would be equivalent to passing both the Series 63 and Series 65 exams.  Additionally, individuals are required to pass the Series 7 exam as a prerequisite for taking the Series 66.  This post will provide an overview on the Series 66 exam and some thoughts on both taking and passing the exam.

The Series 66 Basics

What: The exam has a time limit of two hours and 30 minutes and a total of 110 questions, 10 of which are “pretest” questions and do not count in your final score.  The exam covers the following topics: Economic Factors and Business Information; Investment Vehicle Characteristics; Client Investment Recommendations and Strategies; and Laws, Regulations, and Guidelines, including Prohibition on Unethical Business Practices.  You must earn at least 75% to pass the exam.

Where: You can take the exam at most Pearson VUE or Prometric testing centers.

When: You should probably sign up for the exam at least a week prior to taking it, and you can choose the time and date on either the Pearson or Prometric website when you register.

Why: The exam is required for those individuals who want to become both securities agents (generally brokers) and investment adviser representatives.

How to sign up

You can register for the exam by submitting a Form U-4 or Form U-10 through the IARD system online.  Please not that, effective September 15, 2010, FINRA requires individuals to use either their CRD number or FINRA ID number in order to schedule an exam and no longer accepts social security numbers.  If you have any questions regarding registering for an exam, be sure to ask your law firm, compliance consultant, or feel free to contact us.

The cost to take the exam is $128.

How to study for the exam

It is recommended that you obtain a study guide and thoroughly read the entire guide.  NASAA (North American Securities Administration Association) provides a study guide available for download on their website.  Also, Kaplan provides a useful study guide that presents the study material in a simple and easy-to-understand way, and their practice questions are very similar to questions you are likely to see on the actual exam.

Take at least two to three practice exams prior to taking the test, possibly more.  Use memory refreshers such as note cards or other review materials.  Do not cram the morning of the test, as this will probably only make you more anxious.  In fact, it is recommended that you take the exam in the morning after a full night’s rest.

Day of exam

Arrive at the testing center at least 45 minutes prior to taking the exam to allow yourself time to review some of your notes beforehand.  The proctor will require you take off your jackets and place your belongings, including your study material, in a provided locker.  Be sure to have woken up early enough to eat breakfast beforehand and be fully alert during the test.

The exam

The exam is computer-based and will initially instruct you on how to properly answer and mark the following questions.  Note that the beginning of the exam will most likely include the easiest questions, and then the questions will get harder as you reach the middle.  Always attempt to make the most educated guess on questions you do not understand.

The length of the exam might require you to pause and use the restroom or take a break.  Allow yourself time to step away from the computer for a moment, take a drink, and gather your thoughts.  When you encounter difficult questions, you always have the option of marking the question for review.  Never spend an extended period of time on a question, as you will just waste time on answering other questions you might know better.

After you have completed the questions, you will have the option of changing any of your answers.  After completely answering everything, you will receive your score immediately.

If you don’t pass

A number of managers who take the exam do not pass or only come close to passing.  If this is the case, you will need to wait another 30 days before re-taking the exam.  If you do not pass the exam the second time, you will need to wait another 60 days before taking the exam.  If you do not pass either the third or fourth attempt, you will need to wait at least 180 days before taking the exam again.  There is no limit on the number of times allowed for taking a test.

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Bart Mallon, Esq. runs the Hedge Fund Law Blog and provides hedge fund start up and legal services through Cole-Frieman & Mallon LLP. He can be reached directly at 415-868-5345.

NFA Petitions CFTC to Amend Rule 4.5

Wants Managers of Commodity/Futures Mutual Funds to Register as CPOs

On August 18, 2010, the NFA filed a revised Petition for Rulemaking with the CFTC requesting that it amend CFTC Rule 4.5 with respect to managers to mutual funds which offer futures and commodities investment opportunities.  Generally, a manager operating a mutual fund that invests in futures and commodities would be a commodity pool operator and would need to register as such with the CFTC.  However, under current CFTC Rule 4.5, the manager could seek exclusion from such registration.  The NFA has become concerned about mutual funds that are not subject to the CFTC/NFA regulatory regime and that are marketed to retail customers as a way to invest in futures and commodities.  The NFA is requesting amendment of Rule 4.5 to restrict this kind of activity.

Background

CFTC Rule 4.5 provides an exclusion from the definition of the term “commodity pool operator” for certain otherwise regulated persons in connection with their operation of specified trading vehicles, including investment companies registered under the Investment Company Act of 1940.

Prior to August 2003, mutual fund managers seeking eligibility for exclusion under Rule 4.5 were required to meet the following requirements:

  • they could not market participation in the mutual fund as participation in a commodity pool or a vehicle for trading commodities or futures;
  • they had to represent that commodity futures or options contracts entered into by the fund were for bona fide hedging purposes; and
  • they had to demonstrate that the aggregate initial margin and/or premiums for non-hedging positions did not exceed 5% of the liquidating value of the fund’s portfolio (after taking into account unrealized profits and losses).

In August 2003, the CFTC eliminated these requirements as a condition to be eligible under Rule 4.5.  The NFA is now petitioning for the CFTC to restore these conditions for eligibility.

NFA Petition for Rulemaking

The NFA’s Petition discusses the context for requesting this amendment.  In particular, the NFA has become aware of three mutual funds that recently filed for exclusions under Rule 4.5.  These funds are marketed as vehicles for commodity futures investment, with investments in derivatives and futures products made indirectly through their wholly-owned and controlled subsidiaries (for tax and mutual fund regulatory purposes).  In one case, a fund invests up to 25% of its total assets in a subsidiary that leverages assets at a 4:1 ratio–achieving a futures exposure of the full net value of the fund.

The NFA is concerned that such funds, which are active in the commodity futures industry, are not regulated as CPOs by the CFTC and NFA.  The futures mutual fund manager can file a notice with the NFA claiming the Rule 4.5 exclusion under the Commodity Exchange Act, as amended.  Accordingly, the fund is not subject to registration or regulation as a commodity pool.  Through its Petition, the NFA seeks to ensure that managers of registered investment companies that are marketed as a commodity pool or an investment vehicle for trading in commodity futures and options and whose funds engage in more than 5% of futures are subject to the appropriate oversight and regulatory requirements.

“No-Marketing” and the 5% Limitation

At the time the CFTC amended Rule 4.5, it also adopted Rule 4.13(a)(4) to provide an exemption to CPO registration if every natural person pool participant is a “qualified eligible person.”  The NFA argues that to the extent this exemption served as a reason to eliminate the “no marketing” and “5% trading test” from Rule 4.5, the CFTC should reexamine whether such reasoning is still valid.

When the CFTC amended these rules, it did so under the presumption that the qualifying entities, such as the mutual funds discussed in this article, were “otherwise regulated” and “may not need to be subject to any commodity interest trading criteria.”  But, the NFA is asserting that things have changed since the 2003 amendment and the rationale for the amendments is arguably no longer appropriate or valid.  Such registered investment companies that market themselves as a commodity pools or vehicles for trading in commodity futures or options to retail customers, who may be unsophisticated investors, or engage in more than 5% of non-hedging futures trading should be subject to the rules and regulations of the CFTC and NFA, the appropriate regulatory regime that protects customers participating in the commodity futures markets.

Comments by CFTC Commissioner

On September 1, 2010, CFTC Commissioner Scott O’Malia released a statement regarding the NFA petition which urged the CFTC to “expeditiously” move forward and adopt the NFA’s requested amendments.  The Commissioner stated:

Until the recent influx of new mutual funds specializing in futures trading, the use of the exclusion, in effect a form of regulatory arbitrage, was innocuous. However, continuing to allow FMFs to operate by evading CFTC oversight and its substantial disclosure obligations now poses increased risks to the market and to retail investors.

and

Without CFTC and NFA oversight, FMFs and other such funds that mimic CPOs, but do not abide by the same structure, will continue to avoid specific disclosures mandated for CPOs in the interest of consumer protection including: disclosures over fund risk exposure; performance returns; fee structures; and advisor conflict of interest information.

Future of Rule 4.5

It is clear that a new Rule 4.5 would be fiercely contested by current mutual fund managers who are investing in futures/commodities.  The big issue for managers will be an increase in start-up and compliance costs as well an increase in infrastructure requirements to comply with CFTC Regulations.  This will undoubtedly increase costs to mutual fund investors (and, the NFA argues, potentially increase investor protection).

However, nothing has happened yet.  Although the NFA asked the CFTC to amend the regulation, the CFTC will need to publish proposed amendments for public comment.  After receiving comments, the CFTC would be permitted to issue final regulations.  However, we do not think it is likely that the CFTC is going to focus its rule making (amending) efforts on issues that don’t fall under the Dodd-Frank act.  As the CFTC is under-resourced for this requirements of Dodd-Frank, it is unlikely to take up any outside initiatives over the next 9-12 months as they focus on other rule making efforts such as the OTC derivatives reform.

Other resources:

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Cole-Frieman & Mallon LLP provides comprehensive CFTC and NFA compliance and regulatory support for investment managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Hedge Fund Events August 2010

The following are various hedge fund events happening this month.  Please email us if you would like us to add your event to this list.

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Aug 2-3

August 3

August 3

August 5

August 5

August 9-13

August 11

August 11

August 12

August 12

August 22

August 24

August 24-26

August 25-27

August 25-27

August 31 – September 1

August 31 – September 3

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Bart Mallon, Esq. runs the hedge fund law blog and provides hedge fund registration and compliance services to hedge fund managers through Cole-Frieman & Mallon LLP, a leading hedge fund law firm.  He can be reached directly at 415-868-5345.

Commodity Position Limits After Dodd-Frank

CFTC to Establish Energy Position Limits

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”) includes a number of key provisions which will affect the investment management industry in important ways. For example, the Act includes a mandate for the CFTC to impose position limits across different markets, including the energy markets, the agricultural markets and with respect to trading in certain OTC derivatives. These new position limits must be implemented by CFTC orders or through rulemakings within the next six to nine months depending on the individual markets.

New CEA Section 4a(c)

The Act establishes new SEC Section 4a(c), portions of which we have reprinted below. Generally the new sections will require the CFTC to do the following:

  • establish limits on “exempt commodities” within 180 days of the passage of the Act. [The term “exempt commodity” is defined in CEA Section 1a(14) to generally include those commodities which are not financially based commodities and not agricultural commodities. Generally the import of this provision is to have the CFTC implement position limits on energy related commodities and futures.]
  • establish limits on agricultural commodities within 270 days of the passage of the Act.
  • establish the aggregate number or amount of positions in certain contracts based upon the same underlying commodity that may be held by any person, including any group or class of traders, for each month.

The above requirements are generally subject to “bona fide hedging” exemptions and the new Section 4a(c)(2) requires the CFTC to define what constitutes a bona fide hedging transaction.

* Please note the above is a broad generalization of the applicable new sections of the CEA

CFTC’s Previous Efforts to Set Energy Position Limits

To an extent, we will look to the CFTC’s prior efforts to see where they may land with respect to setting limits. In January 2010, the CFTC proposed position limits designed to prevent any one participant from developing a concentration of futures positions (see generally Federal Register Release 75 FR 4143). The proposed limits would have restricted the position energy traders could hold and addressed concerns many lawmakers had about the connection between those traders and rising energy prices. While the proposed limits only applied to four exchange-traded energy commodities (crude oil, natural gas, and two other types of fuel), the CFTC will be revisiting those efforts to meet the new, more expansive mandate under the Wall Street Reform Act. [Note: you can view previous comments from the public on this issue on the CFTC website.]  The CFTC will be working with other agencies, including the SEC, the Federal Reserve Board, and other regulators in its efforts.

Likely Impact

These mandates will have a significant impact on the energy futures market. In 2009, more than 377 million energy futures and options contracts were traded on CFTC-regulated exchanges and this number is anticipated to increase. Energy traders will now face position limits with respect to the energy contracts that were previously largely unregulated. In addition, it is important to note that under the Act, the CFTC can set position limits not only on persons, but also on any “group or class of traders”–which means it could apply a limit, for example, to all airlines in the aggregate. While we will not know the full impact for some time, when the limits are implemented there are likely to be some groups and individuals who will need to carefully monitor their positions.

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New CEA Provisions

Section 4a(a)(2) of the Commodity Exchange Act

‘‘(2) ESTABLISHMENT OF LIMITATIONS.—

‘‘(A) IN GENERAL.—In accordance with the standards set forth in paragraph (1) of this subsection and consistent with the good faith exception cited in subsection (b)(2), with respect to physical commodities other than excluded commodities as defined by the Commission, the Commission shall by rule, regulation, or order establish limits on the amount of positions, as appropriate, other than bona fide hedge positions, that may be held by any person with respect to contracts of sale for future delivery or with respect to options on the contracts or commodities traded on or subject to the rules of a designated contract market.

‘‘(B) TIMING.—

‘‘(i) EXEMPT COMMODITIES.—For exempt commodities, the limits required under subparagraph (A) shall be established within 180 days after the date of the enactment of this paragraph.

‘‘(ii) AGRICULTURAL COMMODITIES.—For agricultural commodities, the limits required under subparagraph (A) shall be established within 270 days after the date of the enactment of this paragraph.

‘‘(C) GOAL.—In establishing the limits required under subparagraph (A), the Commission shall strive to ensure that trading on foreign boards of trade in the same commodity will be subject to comparable limits and that any limits to be imposed by the Commission will not cause price discovery in the commodity to shift to trading on the foreign boards of trade.

‘‘(3) SPECIFIC LIMITATIONS.—In establishing the limits required in paragraph (2), the Commission, as appropriate, shall set limits—

‘‘(A) on the number of positions that may be held by any person for the spot month, each other month, and the aggregate number of positions that may be held by any person for all months; and

‘‘(B) to the maximum extent practicable, in its discretion—

‘‘(i) to diminish, eliminate, or prevent excessive speculation as described under this section;

‘‘(ii) to deter and prevent market manipulation, squeezes, and corners;

‘‘(iii) to ensure sufficient market liquidity for bona fide hedgers; and

‘‘(iv) to ensure that the price discovery function of the underlying market is not disrupted.

Section 4a(a)(6) of the Commodity Exchange Act

‘‘(6) AGGREGATE POSITION LIMITS.—The Commission shall, by rule or regulation, establish limits (including related hedge exemption provisions) on the aggregate number or amount of positions in contracts based upon the same underlying commodity (as defined by the Commission) that may be held by any person, including any group or class of traders, for each month across—

‘‘(A) contracts listed by designated contract markets;

‘‘(B) with respect to an agreement contract, or transaction that settles against any price (including the daily or final settlement price) of 1 or more contracts listed for trading on a registered entity, contracts traded on a foreign board of trade that provides members or other participants located in the United States with direct access to its electronic trading and order matching system; and

‘‘(C) swap contracts that perform or affect a significant price discovery function with respect to regulated entities.

Section 4a(a)(7) of the Commodity Exchange Act

‘‘(7) EXEMPTIONS.—The Commission, by rule, regulation, or order, may exempt, conditionally or unconditionally, any person or class of persons, any swap or class of swaps, any contract of sale of a commodity for future delivery or class of such contracts, any option or class of options, or any transaction or class of transactions from any requirement it may establish under this section with respect to position limits.’’.

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Cole-Frieman & Mallon LLP provides legal support and futures and commodities compliance services to all types of investment managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

SEC Approves ADV Part II Update

New Form to Require More Disclosure

On July 21, the SEC approved changes to the Form ADV Part II which are designed to provide more and better information to investors.  Currently Part II (and Schedule F which qualifies much of the information on Part II) contains a series of check the box options and also provides much of the same information which is also provided on Form ADV.  The changed proposed below will go into effect 60 days from the publication in the Federal Register which means that most advisers will need to have the new Part II in place by the first quarter of 2011.  In addition to traditional investment advisers, the new Part II disclosure requirements will also be applicable to hedge fund managers who are subject to registration after the passage of the Dodd-Frank reform bill.

The proposed major changes include the following:

  • Increased narrative – currently Part II and Schedule F are composed of a series of check the box answers describing an adviser’s business.  The SEC wants to move towards more of a narrative, “plain English” approach to disclosure which will be “clear and concise”.
  • Discussion of advisory business and fee structure – more disclosure will be required about the advisor’s business and the fee structure.  Increased disclosure will be required about expenses like brokerage and custody fees.
  • Performance fee discussion – the big issue is that if a manager charges performance fees to some accounts and not others, the manager will need to explain the conflicts of interest which are involved.
  • Discussion of investment methodology and risk factors – the manager will be required to explain the material risks involved in the investment program.
  • Disciplinary information – all disciplinary information material to the adviser’s business will need to be disclosed.  If there is new disciplinary disclosures which become necessary after the relationship has been established, the adviser will need to promptly update the client.
  • Supplements – the adviser will need to provide supplements to the client regarding the specific person who will be providing investment advice to the client.  This supplement will include information about the person’s education, business experience, disciplinary history, etc.

After the changes become effective, both hedge fund managers and other investment advisers will need to update their forms and also update their compliance manuals and policies and procedures.  Managers should also note that the information included in Part II will be publicly available online.

While we completely agree with appropriate and easy to understand disclosure, some of the proposed changes may have the unintended effect of creating brochures which are so long and comprehensive that investors will simply not read them.  For example, we have discussed “prospectus creep” and there is the possibility for this to happen with the Part II -especially with respect to risk disclosures.  Managers and lawyers will certainly err on the side of over-disclosure instead of under-disclosure when faced with a potential risk factor which may or may not be “material” in the eyes of the SEC (see, especially, the Goldman case).

What we see with the supplements is essentially a first step towards developing a self-regulatory organization (SRO) to oversee investment advisers.  FINRA has shown a willingness to take on this responsibility and it has become an even greater likelihood as the SEC is tasked with greater responsibilities under the Dodd-Frank bill.  While we believe that a SRO can relieve much of the regulatory burden of a government agency (see the NFA), we must note that all SROs have their own issues and this must be weighed against the increased costs (both in time and money) to investment advisers.

Text of Chairman Shapiro’s speech can be found here.
SEC News Release can be found here.

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Cole-Frieman & Mallon LLP provides legal support and hedge fund compliance services to all types of investment managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.